June 2012 Financial Services regulatory alert Basel 2.5: US Market Risk Final Rule On 12 June 2012, the Board of Governors of the Federal Reserve System (Federal Reserve Board), the Office of the Comptroller of the Currency (OCC) and the Federal Deposit Insurance Corporation (FDIC) (collectively, the agencies) released the US Basel 2.5 Market Risk Final Rule, titled Risk-Based Capital Guidelines: Market Risk (Market Risk Final Rule or Final Rule). The Final Rule is effective 1 January 2013. It was approved by the Federal Reserve Board at its meeting on 7 June 2012 and will be jointly finalized after the OCC and the FDIC have completed their internal review and approval procedures. The scope of application is the same as under US Basel I, applying to US banking organizations with aggregate trading assets and trading liabilities equal to at least US$1 billion or at least 10% of total assets. The agencies estimate a threefold increase in market risk regulatory capital charges as a result of the implementation of the Market Risk Final Rule. This estimated impact is generally consistent with quantitative impact studies released by the Basel Committee on Banking Supervision (BCBS). 1 1 Basel Committee on Banking Supervision, Analysis of the trading book quantitative impact study, October 2009, (www.bis.org/publ/bcbs163.htm). The Final Rule generally preserves the requirements of the two related US Notices of Proposed Rulemaking (NPR) that were released in 2011 (collectively, 2011 NPRs), with the most significant changes related to the standardized specific risk methodologies. 2 Importantly, the Final Rule reaffirms the consistency of the market risk regulatory capital regulation with the Volcker Rule, informing firms subject to the Final Rule that their market risk regulatory capital infrastructure is an appropriate stepping stone toward Volcker compliance. The Market Risk Final Rule does not only have implications for firms that are currently subject to US market risk regulatory capital, but other firms as well: Savings and loan holding companies (SLHCs) and federal and state savings associations. The agencies also released an NPR titled Regulatory Capital Rules: Advanced Approaches 2 Risk-Based Capital Guidelines: Market Risk, 1 January 2011, (http://www.gpo.gov/fdsys/pkg/fr-2011-01-11/pdf/2010-32189.pdf) or January 2011 NPR ; and Risk-Based Capital Guidelines: Market Risk; Alternatives to Credit Ratings for Debt and Securitization Positions, 21 December 2011, (http://www.gpo.gov/ fdsys/pkg/fr-2011-12-21/pdf/2011-32073.pdf) or December 2011 NPR. Risk-based Capital Rule; Market Risk Capital Rule on 7 June 2012 that proposes to expand the scope of the application of the Market Risk Final Rule to SLHCs and to state and federal savings associations that meet the market risk applicability thresholds. 3 Firms impacted by Dodd-Frank 939A. The Final Rule represents one of the first regulations to finalize the alternative approaches to the use of agency credit ratings due to the Dodd-Frank Act prohibition of the required use of agency credit ratings in regulation, and provides insights as to what alternative methods will likely be applied for broader regulation. Market risk capital components The key components of charges that will comprise minimum required market risk capital under the Market Risk Final Rule are summarized in Figure 1. 3 Regulatory Capital Rules: Advanced Approaches Riskbased Capital Rule; Market Risk Capital Rule, 7 June 2012, (http://www.federalreserve.gov/newsevents/ press/bcreg/bcreg20120607a3.pdf).
Figure 1. Market Risk Final Rule market risk capital components Basel I US regulations + VaR measure (general market risk and specific risk) Total market risk capital Standardized specific risk measure New Basel 2.5 charges Stressed VaR measure (general market risk and specific risk) Incremental risk charge (unsecuritized credit positions with modeled specific risk) Comprehensive risk measure (correlation trading portfolios with modeled specific risk) Market risk component VaR measure (general market risk and specific risk) Standardized specific risk measure Stressed VaR measure Incremental risk charge (IRC) Comprehensive risk measure (CRM) Regulatory methodology Max [99% 10-day VaR prior day, 99% 10-day VaR 60-day avg x (3-4)] Firms may scale one-day VaR by 1 0 but must justify scaling General market risk VaR must capture interest rate, equity, commodity, FX and credit spread risks Specific risk VaR must capture event risk and idiosyncratic risk Risk weights for equities by liquidity (diversified index or others) Risk weights for debt and securitization positions by product type and applicable methodology OECD country risk classification approach for debt positions issued by sovereigns, depository institutions and public sector entities Fixed risk weights for debt positions issued by supranational, multilateral development firms, government-sponsored entities, and corporations with no issued and outstanding public instruments Investment grade approach for corporations with issued and outstanding public instruments Simplified Supervisory Formula Approach (SSFA) and/or Supervisory Formula Approach (SFA) for securitization positions Same VaR methodology and multiplier but with data representing a continuous 12-month period of stress Antithetic data can be used as appropriate Must capture default and migration risks Measure losses at 99.9% confidence level over one-year capital horizon either under the assumption of a constant level of risk or under the assumption of constant positions Assign minimum liquidity horizon of the lower of three months or position contractual maturity Must capture all material price risks, including default and migration risks Measure losses at 99.9% confidence level over one-year capital horizon either under the assumption of a constant level of risk or under the assumption of constant positions Assign minimum liquidity horizon of the lower of three months or position contractual maturity Additional requirements Minimum one-year lookback period Recognizes correlation across risks Requires robust risk-factor specification and monthly minimum frequency of data updates and must be capable of more frequent updates as needed Backtesting required against daily clean P&L that excludes fees, commissions, reserves, intraday trading and net interest income Revised risk weights for equity, debt and securitization positions Securitization positions not in the correlation trading portfolio must use the standardized approach Expanded allowance of netting and offsetting of credit products consistent with Basel 2.5 Advanced approaches firms must use supervisory formula approach for qualifying securitization positions for purposes of advanced measure for market risk Calculated at least weekly; capital charge is max [SVaR most recent, SVaR 12-week avg x (3-4)] Stressed VaR measure must be no less than the VaR measure Firms must develop policies and procedures describing their processes to identify and update their stress periods Applies to unsecuritized credit products in the trading book. Banks may also include equity products subject to regulatory approval Calculated at least weekly; capital charge is max [IRC most recent, IRC 12-week avg ] Applies to the correlation trading portfolio Calculated at least weekly; capital charge is max [CRM most recent, CRM 12-week avg ] An initial capital surcharge equal to 8% of the standardized specific risk measure for the correlation trading portfolio will be applied for a period of at least one year and may be replaced over time with a capital CRM floor equal to 8% of the standardized specific risk measure for the correlation trading portfolio Firms will need to perform regulatory-prescribed stress tests 2 Basel 2.5: US Market Risk Final Rule
Observations on the Final Rule Comparison with the 2011 NPRs The Market Risk Final Rule is substantially similar to the rules set forth in the 2011 NPRs. However, the Final Rule provides certain modifications and clarifications to the requirements in the 2011 NPRs with the following highlights: Comprehensive risk measure surcharge (CRM) (modification). The Market Risk Final Rule reduces the CRM surcharge that is added to the CRM model charge to 8% from 15% of the standardized specific risk charge of regulatory correlation trading portfolios. Consistent with the January 2011 NPR, the CRM surcharge transitions to the use of a CRM floor of 8% of the standardized specific risk charge, whereby the CRM charge will be the higher of the modeled CRM charge or 8% of the CRM portfolio standardized specific risk charge. This transition will occur after a firm has met the CRM model requirements for at least one year and received CRM model regulatory approval. The CRM floor of 8% is the current standard under the international Basel 2.5 rules. Standardized specific risk charges Corporate debt positions (modification). The Market Risk Final Rule replaces the financial indicator based approach introduced in the December 2011 NPR for corporate debt positions with an investment grade approach for all corporate debt positions that have issued and outstanding publicly traded instruments. The investment grade approach was originally proposed by the OCC in the NPR titled Alternatives to the Use of External Credit Ratings in the Regulations of the OCC, released on 29 November 2011 (Ratings Alternatives NPR). 4 To consider a position to be investment grade, firms are required to determine that the risk of default of the obligor is low and the full and timely repayment of principal and interest is expected. In the Ratings Alternatives NPR, the agencies acknowledge that under the investment grade approach, external credit ratings may still be used as part of a firm s assessment of the risk of default of a corporate debt position, but that firms are also expected to supplement any use of external ratings with additional due diligence processes and analyses that are indicators of financial performance. Neither the Final Rule nor the Alternatives Ratings NPR provides quantitative guidance as to what constitutes a low risk of default. Securitization positions (modification). The structure and calibration of the Simplified Supervisory Formula Approach (SSFA) is modified in the Market Risk Final Rule to replace the flexible capital floor based on cumulative losses with an adjustment based on a forward-looking assessment of underlying delinquencies. Additionally, advanced approaches 4 Alternatives to the Use of External Credit Ratings in the Regulations of the OCC, 29 November 2012, (http://www.gpo.gov/fdsys/pkg/fr-2011-11-29/html/2011-30428.htm). firms (Basel II firms) will now be able to use the more complex but also more risk-sensitive Supervisory Formula Approach (SFA). 5 The SFA and SSFA are also applicable to nth-to-default derivatives, irrespective of whether the firm is a net protection seller or net protection buyer. Securitization positions for which a firm does not use the SFA or SSFA would be subject to a 100% risk-weighting factor (1,250% risk-weight equivalent). The Final Rule includes the securitizations due diligence requirements that were first highlighted in the January 2011 NPR, requiring a firm to demonstrate that it has a comprehensive understanding of the features of a securitization position that would materially impact the performance of the position. Matching, netting and offsetting (clarification). The Market Risk Final Rule provides clarification to the matching criteria for netting and offsetting of debt or securitization positions and corresponding credit derivative hedges. In the case of sold credit protection, the maturity date of the hedge can be within 30 business days of the maturity date of the underlying position being hedged. In the case of purchased protection, it must be later than the maturity date of the underlying position being hedged but no later than the next immediate standard maturity date for that credit derivative hedge. Clarification is also provided that it is allowable to net exposures between individual issuer and untranched index positions. Sovereign exposures (modification). The Final Rule generally preserves the December 2011 NPR Organization for Economic Cooperation and Development (OECD) country risk classification (CRC) methodology to determine standardized specific riskweights for sovereign debt positions. However, it does provide a broader definition of default for sovereigns compared to the December 2011 NPR, increasing the risk sensitivity of the measure. Modeled specific risk event risk definition (clarification). The Final Rule clarifies the definition of event risk as the risk of loss on equity or hybrid equity positions as a result of a financial event, such as the announcement or occurrence of a company merger, acquisition, spin-off or dissolution. Such clarification of the definition of event risk is not included in the international Basel 2.5 standards. Two-way liquid market (clarification). The Final Rule also clarifies that covered positions do not necessarily need to be traded within a liquid two-way market but must be valued by reference to such market. It also modifies the requirement for settlement of positions within five days, as proposed in the January 2011 NPR, to within a relatively short period of time. 5 Include all banks reporting consolidated total assets of US$250 billion or more, consolidated total on-balance sheet foreign exposure of US$10 billion or more, and those opting in. Basel 2.5: US Market Risk Final Rule 3
Regulatory VaR backtesting (modification). The Market Risk Final Rule relaxes the implementation timeline for conducting VaR backtesting against clean P&L (i.e., profit and loss, excluding fees, commissions, reserves, net interest income and intraday trading) in order to determine the VaR multiplication factor. The Final Rule allows firms up to one year after the later of either 1 January 2013 or the date on which a firm becomes subject to the Market Risk Final Rule to begin VaR backtesting using clean P&L. Prudential valuation standards exclusion (modification). The Final Rule relaxes the requirement for prudent valuation of covered positions by removing valuation adjustments for future administrative costs, previously included in the January 2011 NPR. The agencies acknowledge the difficulty and arbitrary nature of calculating such an estimate. General adjusted and advanced adjusted risk-weighted assets (modification). The Final Rule requires firms subject to the advanced approaches rules to calculate two measures of market risk-equivalent assets: the general adjusted risk-weighted assets, utilizing SSFA for securitization positions, and the advanced adjusted risk-weighted assets, utilizing SFA, provided the firm has sufficient information to calculate SFA for securitization positions. The remaining market risk capital components used in the two measures of market risk-equivalent assets are the same under the Final Rule. Summary of key issues Despite the similarity of the Final Rule to the 2011 NPRs, the complexity and scale of the efforts required to implement the Final Rule suggest that firms may still have significant work ahead to fully comply with the Final Rule by the 1 January 2013 effective date. Key implementation challenges are further described below. Risk-weighted assets analytics and front-office awareness. While not an explicit regulatory requirement, firms will likely need to continue to ensure that their front offices are aware of the impacts of the new market risk capital charges on the profitability of their trading desks, and ultimately develop analytics to measure and charge capital to desks for their market risk regulatory capital costs. Trading book/banking book. Firms may be required to move certain illiquid positions to the banking book to reflect the changes in the boundary requirements under the Final Rule. Additionally, given the alignment of standardized specific risk charges between the trading and banking books for positions such as securitizations, firms may benefit from having certain positions in the banking book, as they would not be subject to the general market risk VaR and stressed VaR-based capital charges in the trading book. Market liquidity. The Final Rule requires the market liquidity of covered positions to be considered within documented policies and procedures supporting firms assessments as to which positions qualify as covered positions and documenting firms approaches to managing and valuing covered positions. Additionally, the liquidity horizon assumptions of incremental risk charge (IRC) and CRM models should be justified within related model documentation and must be described as part of firms market risk disclosures. Firms will likely need to consider further formalizing practices across the front office, finance and risk functions to maintain and analyze relevant information such as aged inventory reports, open interest, the number of market participants, trade volume and bid-offer spreads in order to support these market liquidity assessment requirements. Economic hedges. The Final Rule establishes requirements for the identification and treatment of covered positions, but does not provide insights into the treatment of positions that are intended as hedges of banking book positions. Firms may consider including within their policies formal criteria regarding which positions qualify as banking book positions, such as positions already formally assessed as hedges through processes like hedge accounting or those that qualify as credit risk mitigants under capital rules. Additionally, using the Volcker Rule as a potential guidepost, firms may consider enhancing the overall governance and infrastructure supporting banking book economic hedges to include formal documentation of hedge strategies, the identification of risks being hedged, linkages between hedges and the underlying positions being hedged, and definitions of acceptable measurements of correlation and related hedge effectiveness analysis. Position identification: IRC, CRM and standardized specific risk charge. Firms may also face operational challenges in implementing formal processes, system capabilities and related controls to identify, flag and segment existing and future covered positions, such as: Unsecuritized debt positions subject to IRC, including identifying IRC model approved and non-model approved sub-portfolios Correlation trading positions subject to CRM, including identifying CRM model approved and non-model approved subportfolios, such as CDO index tranches, bespoke CDO tranches, nth-to-default credit derivatives, and single-name CDS used to hedge these positions 4 Basel 2.5: US Market Risk Final Rule
Non-correlation securitization positions subject to standardized specific risk capital charges Model development, validation and data. Significant efforts may also be required for firms to finalize and implement new models, infrastructure and controls to support the new risk measurements and related reporting. Firms should also be finalizing their independent model validations and preparing to submit their market risk regulatory capital model packages to supervisors for regulatory approval. Clean P&L for regulatory VaR backtesting. As reflected by the one-year extension of the effective date required to backtest using clean P&L, firms may still face challenges in developing the infrastructure to support the calculation of daily clean P&L that excludes fees, commissions, reserves, intraday trading and net interest income from the actual profit and loss. For instance, firms may need to integrate different sub-ledgers, source systems and general ledger reconciliation processes into the architecture and infrastructure, which may substantially differ from their current practices for reporting books and records P&L. What should firms do now? Conduct impact analyses and update implementation plans. Firms that have already been implementing Basel 2.5 processes based on the 2011 NPRs should analyze the Final Rule to determine gaps to existing implementation plans to comply with the Final Rule by the 1 January 2013 effective date. Conduct dialogue with regulators. Firms will be expected to engage with regulators to address final interpretation questions and to coordinate regulatory model reviews. the capacity to meet their US effective dates may also consider coordinating their final implementation efforts with assessments of the Fundamental review consultative document and potentially submit comment letters by the 7 September 2012 deadline. For more information regarding Ernst & Young s market risk capital advisory services for financial services institutions, please visit www.ey.com/us/financialservices or contact: Qingji Yang Principal, Advisory, Financial Services +1 212 773 1490 qingji.yang@ey.com Michael Sheptin Principal, Advisory, Financial Services +1 212 773 6032 michael.sheptin@ey.com Manhua Leng Executive Director, Advisory, Financial Services +1 212 773 2891 manhua.leng@ey.com Jim Embersit Executive Director, Advisory, Financial Services +1 202 327 6078 jim.embersit@ey.com Re-evaluate business impacts. Firms will need to reassess their business strategies to best address the impacts of the Final Rule. Plan for the fundamental review. The BCBS released its Fundamental review of the trading book (Fundamental review) consultative document on 3 May 2012. 6 The document, which is open for comment through 7 September 2012, proposes significant changes to many aspects of the market risk capital framework, including the definition of the trading book boundary and changes to model and standardized approach measures. It also noticeably does not include a proposal to integrate credit valuation adjustment (CVA) risk into the market risk capital framework. Firms that have 6 http://www.bis.org/publ/bcbs219.htm. Basel 2.5: US Market Risk Final Rule 5
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